When PivotalPath talked to outperforming hedge funds for a recent study of how they were positioned in the first quarter, managers largely told a story of shifting from low-quality to high-quality stocks beginning at the end of February and into early March as the economic effects of COVID-19 started becoming apparent. But once the data started rolling in, the numbers told a different story.

“They’re all telling me that they’re long high-quality names and short low quality. That’s the view they gave everybody,” said Jon Caplis, CEO at hedge fund research and data firm PivotalPath, in an interview. 

Caplis added that managers that have outperformed this year said they sold stocks with high leverage and moved into those with less debt at the end of February and beginning of March. Portfolio managers reduced their exposure to companies with liquidity issues or those that were highly dependent on travel.

But when PivotalPath analyzed its Equity Diversified Index — which represents global long-short managers — for Institutional Investor, it found that hedge funds had positive exposure to the so-called quality factor in January 2020, after which their exposure to quality consistently fell. The quality factor refers to companies with higher and more reliable profits, low debt, and other measures of sustainable earnings

PivotalPath reported that the beta to quality — a measure of a portfolio’s exposure to quality stocks — was 0.59 in January. (A beta of 0 means that it has no exposure to the factor.) The ratio fell to 0.16 in February. By March, the measure went negative (-0.60) and fell slightly more in April (-0.62).

“The finding doesn't line up with what we hear from managers, [which is that] managers are long high quality, short low quality. Was this just a short covering and if so, what does this mean for positioning going forward with declining fundamentals?” said Caplis.

In saying they were in quality stocks, hedge fund managers might have been telling people what they wanted to hear, according to Caplis. PivotalPath uses the Dow Jones U.S. Thematic Market Neutral Quality Index as a proxy for quality. 

The index measures the performance of a long-short strategy using a long position in high-quality companies and a short position in low-quality companies. The index rose 11.9 percent in March, while the Standard & Poor’s 500 stock index lost 12.4 percent.

“At some point in March, these managers started shifting their portfolios in a significant way,” said Caplis. “Managers could have been positioned as communicated but began shifting their portfolios in meaningful ways as the Fed announced its whatever-it-takes approach on March 23rd. If they had been net short these low-quality names, and net long the high-quality names, at a minimum they began covering their short positions in March and trimming their winners.”


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A shift away from quality stocks could be beneficial now. In March, the Dow Jones Quality index outperformed PivotalPath’s Diversified Equity Index. But in April, the Diversified Equity Index returned 5.77 percent, while the Dow Jones Quality index lost 0.31 percent.

Caplis noted that hedge fund managers may have also quickly reacted to news that the Federal Reserve was going to support the market in any way it could. In that case, all equities would rise, regardless of fundamentals.

PivotalPath is now hearing that diversified equity long-short funds have a short book that is concentrated in what the research firm calls social-distance losers: businesses like airlines, hotels, casinos, and restaurants, most of which have high leverage.

“It will be interesting to see if beta starts to shift upwards in May, since equity markets have rallied, and managers have been covering shorts and buying longs,” said Caplis. “Hedge funds now look more bullish than they may have let on at the time.”